Basel attacks on credit ratings misfire

Sid Verma
Published on:

The Basel Committee on Banking Supervision’s (BCBS) proposals to reduce lenders' reliance on external credit ratings and boost the risk sensitivity of exposures through new metrics could trigger a slew of unintended consequences, according to a Fitch report.

In recent years, regulators have fought tooth and nail to reduce financial markets’ dependence on global credit rating agencies (CRAs). 

Citing attempts to address conflict-of-interest, risk-management and pro-cyclical fears, regulators have encouraged the growth of  alternative rating agencies, investigated the culture and practices of the big three, and, in the US, removed references to CRAs outright in the Dodd-Frank Act.

Basel Committee Tower-large
BCBS headquarters in Basel
The contentious issue of risk-modelling banks’ sovereign debt portfolios by reference to ratings is now subject to a formal investigation at the Basel level. After all, the e urozone sovereign debt crisis underscored the flaws of the current system whereby banks, in theory, are free to attach zero risk capital to debt issued by their homes states in internal risk models, subject to supervisory discretion.

However, perhaps the most damaging attack to the credit-rating business came in December with the publication of a Basel consultative document aimed at limiting lenders’ freedom to measure risk by reference to credit ratings

In a bid to further micro-manage financial institutions’ asset-liability mismatches, the Basel paper advocates risk-weighting exposures for corporates by a given borrower’s revenue and leverage, rather than ratings. For banks, it suggests common tangible equity ratios and the non-performing assets ratio.

As Euromoney reported in March, these proposals are political dynamite since such measurements fail to discriminate between supervisory, covenant, insurance and accounting standards. It is also likely to constrain the profitability of certain loan portfolios. For example, the risk-weighting attached to corporates would jump from 30%-150% to 60%-300%. 

Meanwhile, the proposed risk weights for mortgages is in the 25% to 100% range, compared with a flat 35% currently, based on the loan-to-value (LTV) ratio and a borrower’s indebtedness.

Given Europe’s dependence on bank lending to finance corporate borrowing, and the relative depth of local capital markets in the US, the proposals, at first blush, threaten to hike the cost of bank capital as the eurozone stages a recovery.

At the end of last month, Fitch released an instructive report calculating the likely impact of the BCBS's proposals on Fitch-rated corporates. While it has a clear self-interest in advocating for the continued use of external credit-rating agencies, Fitch’s calculations are surprising.

From the report:

The proposed use of balance sheet leverage is surprising given the more common use of cash-flow leverage metrics (e.g. debt/EBITDA) in corporate credit assessments, and leads to some surprising results. The new proposals would assign a number of highly-rated issuers to the highest risk buckets, and conversely, would have treated the majority (60%) of defaulted issuers in the Fitch portfolio as low risk (risk weighted below 100%). This indicates that the proposed metrics would fail to discriminate adequately between different credits.

Decrease in Rated Corporate Risk-Weights: Analysis of the Fitch-rated portfolio of global corporates indicates the proposals lead to a decline in average risk weights to 84% from 102% as compared to ratings based risk weights, with lower-rated corporates and cyclical sectors such as property and real-estate benefitting most. Risk weights for higher-rated corporates increased. However, the overall decrease would likely be offset by the proposed increased requirements for off balance sheet exposures. The overall impact will depend on the size and make-up of a bank's portfolio, and the portion of corporate lending to rated entities.

Exposures to Banks

Missing Important Factors, Lack of Comparability: The BCBS proposes to determine risk weights for banks’ exposures to other banks based on the common equity Tier 1 (CET1) risk- based ratio and non-provisioned impaired exposures. In contrast, the current Basel framework provides two options, both ratings-based; the first based on the sovereign rating, and the other (more risk sensitive) based on banks’ issuer ratings. Fitch agrees that asset quality and capital ratios are important considerations in bank credit assessment. But these metrics on their own provide an incomplete basis for credit differentiation, as they omit important factors such as the bank’s operating environment (especially important for emerging-market banks), company profile, governance, liquidity and profitability. The proposed metrics also suffer from lack of comparability and consistency across jurisdictions (as reflected e.g. in the BCBS’s efforts to address consistency of risk-weighted assets, which underpin the CET1 ratio).

Some of these conclusions are pretty damning. Not only are some of the metrics questionable, such as the blunt balance-sheet-leverage metric, their usage could punish low-risk corporates and reward high-risk organizations, such as property and real-estate.

The irony is that Basel has already acknowledged blue-chip corporates offer relative stability for financial institutions, by including the highest-rated corporate bonds, with strong free cash-flow positions, in the liquidity coverage ratio (LCR). Punishing, albeit unintentionally, such institutions through new risk metrics undermines the rationale for the expansion of assets eligible for inclusion in the LCR.

What’s more, the net impact could provide billions of dollars of capital relief for banks’ corporate exposures just as lobbyists deplore the proposals, fearing new onerous risk-weights could curb lenders’ balance-sheet expansion. After all, Fitch calculates the proposals lead to a decline in average risk weights to 84% from 102% as compared with ratings-based risk weights.